Why China's central bank may hold sway in the Year of the Sheep

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Picking the right asset class, individual geographic market and the right funds or stocks to play that choice is not just about finding the best economic growth. Nowhere exemplifies this better than China.

Despite a 140% increase in GDP in absolute, local currency terms over the past seven years, the Shanghai Composite languishes some 46% below its all-time high of 5,903 reached in October 2007. The economy has continued to expand rapidly yet Chinese stocks have suffered a de-rating from what proved to be excessive levels eight years ago, as:

  • the rate of GDP growth has slowed
  • the quality of the growth has come into question, thanks to an over-reliance on capital investment
  • the risks associated to this growth have risen as China’s debt pile has mushroomed.

These concerns were every bit as relevant in the second half of 2014 as they had been during the previous seven years yet the Shanghai Composite stock market index tore higher last year, as it drew strength from three different factors:

  • Hopes for political, social and economic reform in the wake of a major shift in Communist Party policy, initiated at the Third Plenum held in November 2013
  • Government and central bank action to reinvigorate growth, in the form of the Silk Road infrastructure investment scheme and looser monetary policy respectively
  • Autumn’s launch of the Hong Kong-Shanghai Connect trading programme

Fired by all three, sentiment remains buoyant and Shanghai’s return for the past 12 months of 61% in sterling terms puts it pretty much top of the global stock market pile:

Shanghai Composite heads the global performance tables over the past year in sterling-denominated, total return terms

CountryIndexReturns over past year (£ terms)
ChinaShanghai Composite60.9%
IndiaSensex55.3%
USAS&P 50024.1%
JapanNikkei 22517.7%
AustraliaASX 2003.1%
UKFTSE All Share3.1%
EuropeStoxx 6002.4%
BrazilBovespa-3.7%
RussiaRTS-27.3%
   
FTSE All World 15.3%

Source: Thomson Reuters Datastream, AJ Bell Research

For all of this new-found energy, Chinese stocks now pose a conundrum, especially for growth-starved advisers and clients in the West. China may continue to publish GDP growth numbers in the 7%-to-8%-a-year range but the underlying indicators are far less encouraging and the country does need to address both its debts and the imbalance between consumption and capital spending. Whatever the official numbers say, China has its problems.

At the same time, President Xi Jinping and Prime Minister Li Keqiang do seem to be pressing ahead with reform and the People’s Bank of China could well continue to provide monetary stimulus. In a world obsessed with central bank policy this may be enough to keep Chinese stocks bubbling along and there are plenty of ways to play the country’s equity markets via investment companies with variable capital, investment trusts and exchange-traded funds, as the tables below illustrate. Collectives with a broader pan-Asian mandate will also offer exposure.

The best performing Chinese funds over the past five years

OEICISINFund sizeAnnualised five- Dividend yieldOngoing Morningstar 
  £ millionyear performance chargerating
Threadneedle China Opportunities ZNA AccGB00B846CP88123.110.2%n/a0.93%*****
Standard Life Global SICAV China Equities A AccLU0213068272117.68.6%n/a2.02%*****
First State China Growth I AccIE00083687423,469.48.5%n/a2.08%*****
Henderson China Opportunities I AccGB00B5T7PM36507.77.7%1.2%0.89%*****
Fidelity China Focus Y GBPLU04579599392,319.87.1%0.8%1.67%****

Source: Morningstar, for China Equity category. Clean funds only. Where more than one class of fund features only the best performer is listed.

The best performing Chinese funds over the past five years

Investment companyEPICMarket capAnnualised five- DividendOngoing DiscountGearingMorningstar
  (£ million)year performance *Yieldcharges **to NAV rating
JP Morgan ChineseJMC140.16.9%0.9%1.59%-10.6%7%****
Fidelity China Special Situations ***FCSS1,095.2n/a0.9%2.47%-12.6%27%*****

Source: Morningstar, The Association of Investment Companies, for the Country Specialists: Asia Pacific category
* Share price.
** Includes performance fee
*** Launched in April 2010. Shown for information purposes.

The best performing Chinese funds over the past five years

 EPICMarket capAnnualised fiveDividend Total expenseMorningstar 
  £ millionyear performanceyieldratiorating
db x-trackers FTSE China 50 UCITS ETF (DR) 1C (GBP)XX25164.34.6%n/a0.60%***
iShares China Large Cap UCITS ETF GBPFXC666.72.3%n/a0.74%***

Source: ETF.com, Morningstar, for the China Equity category. Physical replication only.
Where more than one class of fund features only the best performer is listed.

Yet care is needed. Dollar strength (see Three key themes take centre stage, 6 February 2015 here) is rarely good for emerging markets, commodity price weakness further warns of caution and in the end it is hard for those us of sat here in the West to truly get a handle on what is happening inside China. Risk-averse clients may therefore choose to look elsewhere in their quest for growth and/or income – at least until key indicators such as rail traffic, electricity output and steel prices show signs that Beijing’s economy is back on a truly firm footing.

From Horse to Sheep

One of the global equity markets’ most remarkable features of the past 12 months has been Chinese stocks’ relentless gallop higher which, rather appropriately, came during the Year of the Horse according to the Chinese zodiac.

The Shanghai Composite index galloped higher during the Year of the Horse

The Shanghai Composite index galloped higher during the Year of the Horse

Source: Thomson Reuters Datastream

Reform and stimulative monetary policy could work their magic again, while the Hong Kong-Shanghai Connect programme should in time further boost liquidity in Chinese stocks. The mechanism links A-shares traded in Chinese companies in Shanghai with H-shares in Chinese companies listed in Hong Kong, allowing Hong Kong-based clients to invest in mainland-quoted paper and China-based clients to invest in Hong-Kong quoteds while settling via their domestic exchanges.

Whether the Shanghai market turns more timid again, as the Chinese calendar takes us from the Year of the Horse to the Year of the Sheep (or, some would say Goat) will depend on the above trio of factors’ ability to further boost confidence and drive valuations higher, as the authorities look to lay the foundations for further sustained economic and social development.

Yet there are some warning signs which advisers and clients need to follow carefully. The market drew great encouragement from the China’s fourth-quarter GDP growth figure of 7.3%, as it came in a fraction above expectations. Yet such numbers are backward-looking and therefore by their very nature useless when it comes to fathoming potential returns from equity markets, which are forward-looking discounting mechanisms.

Moreover, the Chinese GDP numbers are collated within a month and never revised. The equivalent data from the UK and USA are subject to two revisions and the final figure takes the best part of eight weeks to prepare, across geographic areas which are far smaller.

If this sounds cynical, it is meant to and even the Chinese have their doubts about some of the numbers. The Economist ran a story a few years back which quoted now Prime Minister Li Keqiang as saying he preferred to look at three separate economic indicators rather than the headline GDP growth number as they were more reliable. Those data points were

  • rail cargo traffic
  • electricity consumption
  • demand for loans

It should therefore be worth revisiting them now.

Loans and credit

Perhaps the biggest bear case against China rests with the country’s balance sheet. A report published earlier this month by the consultants McKinsey entitled Debt and (not much) deleveraging pulls no punches here, although China is by no means the only country picked out. McKinsey notes global debt has soared from $142 trillion to $199 trillion since 2007, adding that China’s liabilities have rocketed from $7.4 trillion to $28 trillion, or from 158% to 283% of GDP, over the same period.

China’s debts have ballooned since 2007

The Shanghai Composite index galloped higher during the Year of the Horse

Source: McKinsey

It seems unlikely that basing growth on borrowed money can last forever – just ask Greece and most of Southern Europe – and as a result some commentators are waiting for what they believe is the inevitable smash.

The next two charts look at loans offered to domestic Chinese customers by the four largest state-owned commercial banks. Demand growth is still running at more than 10% even if this does represent a slowdown from prior years. It will be interesting to see if the People’s Bank of China’s decision in February to lower banks’ Reserve Requirement Ratio (RRR) by half a percentage point to 19.5% stimulates further lending.

Chinese loan growth remains robust but is slowing …

Chinese loan growth remains robust but is slowing …

Source: Thomson Reuters Datastream

… even as the Shanghai Composite powers higher

… even as the Shanghai Composite powers higher

Source: Thomson Reuters Datastream, AJ Bell Research

Rail and power

The second of Prime Minister Li’s trusted indicators is rail traffic. This seems sensible as for the economy to thrive, goods must be shipped and this in some ways equates the Richard Russell’s Dow Theory and the view that transport stocks must be doing well for the overall equity market to thrive (see Watch the oil price as transport stocks set the tone, 21 November 2014 here).

At first sight, the data are less encouraging on this front.

Chinese rail cargo volumes are tailing off …

Chinese rail cargo volumes are tailing off…

Source: Thomson Reuters Datastream

… even as the Shanghai Composite steams upwards

Chinese rail cargo volumes are tailing off…

Source: Thomson Reuters Datastream, AJ Bell Research

Premier Li's final litmus test also raises questions. Growth in electricity output and consumption looks to be losing its spark and it is hard to believe that China's economy is growing a rate north of 7% when rail cargo growth is negative and increases in power usages stand at barely half that level.

Growth in Chinese electricity output and consumption is sliding even as the Shanghai Composite charges higher

Growth in Chinese electricity output and consumption is sliding even as the Shanghai Composite charges higher

Source: Thomson Reuters Datastream, AJ Bell Research

Cold steel

It may be worth adding a fourth indicator to those used by Li Keqiang, at least according to research from John Clemmow of Barclays Stockbrokers. He makes a powerful case for using steel prices as a gauge of Chinese activity or at least as a measure of how China used to work, before its attempts to shift its economic focus from construction and investment to private consumption.

This perhaps paints a picture that is bleaker than any of the three measures of growth preferred by Prime Minister Li.

The Chinese steel price index remains very soft

The Chinese steel price index remains very soft

Source: Thomson Reuters Datastream, Barclays Research, AJ Bell Research

Clemmow has his doubts as whether Chinese stocks can maintain their momentum of last year but is experienced enough to acknowledge the power of looser monetary policy. Any 'bad' news on the economy could become 'good' news for markets if China's central bank responds with further easing of the RRR, interest rate cuts or efforts to depreciate the yuan.

It may just be that the People's Bank of China will have the ultimate say in where the herd puts its money during the Year of the Sheep, just as central bank policy is doing so much to drive clients’ portfolio preferences in the West.

Russ Mould, AJ Bell Investment Director


russmould's picture
Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.